Why Is India's GST Such a Big Deal?

Tax reform could mean an Indian summer for investors.

By Rob Edens for The Diplomat

August 16, 2016

It isn’t often that tax reforms are greeted with superlatives and hyperbole, but India’s new Goods and Services Tax (GST) — described as “breathtakingly unprecedented” and likened to an injection of “rocket fuel” to India’s economy — has gotten Indian commentators very excited. The GST, which passed on August 9, looks set to unlock India’s latent growth potential. With post-Brexit Britain in the market for new trade deals, British officials would be forgiven for getting a little excited about it too. The reforms, which have been 16 years in the making, aim to simplify India’s Byzantine taxation system by harmonizing the country’s state and central government revenue-raising mechanisms.

Currently, goods in India are taxed by individual states. Services are taxed by the central government, which also levies a welter of further excise and customs duties, surcharges, and cesses, which bog business owners down in hours of paperwork and drive them toward black market suppliers to escape the complicated and expensive work of tax compliance. For companies looking to trade across India’s 1.3 billion-consumer market, the fragmented tax systems often result in double taxation. Deliveries are delayed by hours at interstate checkpoints where goods and cash can be confiscated for running afoul of tax domicile rules.

This all came about after the collapse of communism in 1991 encouraged India to shift away from its socialist leanings and toward free market capitalism. Part of this process involved devolving revenue-raising powers to state governments, but the jumble of tax codes and regulations that emerged from this has slowly strangled Indian companies. The result has been a flourishing of the informal economy: of the 63 million enterprises in India, only 8.5 million pay taxes. The GST is expected to change all of that by subsuming more than a dozen other taxes into one — yet to be decided — rate.

The journey to get to this point has been arduous, with the states determined to maintain their tax raising powers and successive opposition parties, including Modi’s own BJP, blocking the passage of reform for political reasons over the past decade and a half. However, thanks to the present government’s success at lobbying smaller states as well as the retirement of a number of the GST’s most stalwart opponents, Modi was able to marshal the votes needed to get the vote through. There is more wrangling to be done between states — which want the GST to be as high as possible to make up for lost revenue — and the central government, which wants to keep it as low as possible to minimize the risk of inflation. Most commentators expect lawmakers to agree on a final rate of 18 percent in December, once it is approved by a majority of Indian states.

For Modi, who came to power in 2014 after a decade of Congress Party rule ended in a mire of corruption and voter disenchantment, the implementation of the GST would mark the signature achievement of his first term and set him up for re-election in 2019. For decades, India has underperformed in comparison to other developing economies, growing at an average rate of 3.7 percent between 1950 and 1970. Japan and South Korea grew at 10 and 5 times that rate respectively during the same period. The fact that India’s GDP expanded by 7.9 percent in the last quarter, despite the cumbersome tax system and the billions of dollars lost to the informal market, is a testament to India’s potential as a powerhouse of the global economy.

The British Connection

India’s reforms will also be a boon for London. Theresa May, entrusted with the ignominious task of satisfying the demands of Vote Leave despite her largely pro-Remain stance, has been scurrying for solutions. And her eyes are firmly fixed on India. British companies already employ nearly 700,000 people in India and have invested more than $20 billion between 2000 and 2015. The U.K. is India’s largest G20 investor and employer. But trade flows both ways: in recent years India has become the third biggest source of FDI into the U.K., after the U.S. and France.

This being the case, it is little surprise that India was one of the first countries with which the U.K. opened preliminary trade talks in the wake of the Brexit vote. While India has been trying to seal a FTA with the European Union since 2007, talks have progressed quite slowly and are currently deadlocked as Delhi is seeking to renegotiate its Bilateral Investment Treaties with other EU members. Unencumbered by the need to get 28 competing member states on board, the U.K. could get a head start and solidify its presence on the Indian market by signing a deal before the EU.

India’s reforms fit into a rationale of heightened regional competition for foreign investment. Following its nuclear deal, Iran is rejoining the world economy and is out for suitors for its booming oil sector as well as its burgeoning middle class. In June, more than 300 German companies visited the Islamic Republic seeking to tap into the potential of the 78 million strong country. Teheran, meanwhile, is laying out the red carpet for Western investors eager to pony up the $200 billion needed to boost the country’s oil production.

A similar battle for foreign investment is unfolding in Saudi Arabia, where the government wants to wean its dependency on oil, sell off parts of parastatal behemoth Saudi Aramco and create the world’s wealthiest sovereign wealth fund. As in India, the U.K. is one of Saudi’s most important and established trade partners, with more than 200 joint ventures in the Kingdom totaling more than £11 billion in value. Provided Saudi reforms are implemented effectively, that figure could balloon in the near future.

As such, India’s GST system comes at a crucial time for investors shopping for new markets and opportunities for expansion. At a time when Europe is fragmenting, China’s growth engines are sputtering at reduced speed and American presidential candidates are openly talking about trade wars and walls, India is a rare example of a country willing to pursue liberal market reforms.